As Europe Rearms, Bond Funds Are Ripping Up the Rule Book

New sources of funding would be welcome news for a defense industry that’s struggling at times to get buy in from bank lenders, who still worry about falling foul of European ESG regulations. That’s doubly true for smaller startups working on everything from drones to surveillance gear. Junk-debt investors are especially keen to put their money to work.

One manager of a collateralized-loan obligation fund, which are huge buyers of corporate debt, says he’d ignored defense deals in the past because it wasn’t worth the bother, but points to flexibility in current restrictions that only exclude cluster munitions, landmines, biological and chemical weapons, nuclear bombs and firearms. His firm may relax that further if future deals come up.

Another executive at a leading investor in high-yield debt — an important source of finance for younger, riskier companies — says there’s space for plenty of nuance under the ESG category. His clients are usually more worried about carbon than weapons, he adds. A European peer says he’s been responding to pressure from US colleagues to adopt a looser approach.

“There will be a degree of soul searching at European asset managers around the defense sector, especially when your country is spending so much on defense,” says Catherine Braganza, portfolio manager at Insight Investment, which has restrictions around such wagers. “I think it’s time to look again at the ESG criteria around this.”

Trump Void

Investors of many stripes shunned arms manufacturers as they tried to portray themselves as socially responsible. But with European military spending set to soar to fill the void left by President Donald Trump’s faltering support for Ukraine, there’s a rush to follow the money.

Stock investors are already moving en masse to profit from the shift to a war footing, as seen in the proliferation of portfolios focused on weapons makers over the past 12 months. The number of ESG equity funds invested in defense companies has risen 50% to near 1,800 since Russia's invasion of Ukraine in 2022, according to analysis by Bloomberg Intelligence.

With certain European defense-focused equity funds making close to 50% returns this year, cash-rich credit firms want to ensure they don’t miss out. Over the past couple of years, debt investors have seen their markets shrink thanks to an ongoing slowdown in M&A and the incursion of private credit into their domain. The promised wave of lavish armaments spending by Germany and others might be a once-in-a-generation opportunity for financiers.

Some deal-starved lenders are even hoping to see more debt-funded buyouts of defense-related companies by private equity firms.

And it’s not just high-yield investments where there’s a potential opening. Europe’s defense champions such as Britain’s BAE Systems Plc and Italy’s Leonardo SpA are issuers of investment-grade debt. Germany’s Rheinmetall AG and France’s Safran SA have tapped the convertible-bond market.

There are limits, though. Leonardo, for example, makes military equipment including jets, helicopters and torpedoes, but it has been excluded by some funds before because it falls under their “controversial weapons” category.

While Norway’s no.1 pension company KLP does invest in the defense industry, it excludes arms such as nuclear weapons and cluster munitions as “they fail to distinguish between military and civilian targets,” which is “why Leonardo is excluded,” according to Kiran Aziz, KLP’s head of responsible investments.

It’s “not a unified sector,” she says. “It’s challenging to delimit exactly what’s defined as an arms company.”

The opportunity for investment-grade bond investors has a longer timeline, too, because it may be a few years before any ramp-up in production starts to require debt finance. Defense companies could also opt to sell more debt to fund share buybacks, which would be bad for creditors as it weakens balance sheets.

Still, the spike in French satellite operator Eutelsat Communications’ junk bonds displays the eagerness of debt funds to jump aboard the military bandwagon. The company is being touted as a possible replacement for Elon Musk’s Starlink to support Ukraine’s troops and beef up Europe’s broader defenses.

Politics First

Despite complaints from a few bankers about ESG restrictions from regulators, political pressure to relax them is intensifying. Last week more than 100 UK Labour lawmakers and peers called on banks and pensions to rethink “mechanisms that often wrongly exclude all defense investment as ‘unethical’.”

The country’s financial regulator felt moved enough to point out this week that there are no rules actually stopping UK investors with ESG mandates from investing in defense assets. It did, however, add a caveat that this “shouldn’t be confused with financial institutions’ own policies relating to the type of businesses they wish to support and their own risk appetite.”

France is making similar noises about lifting ESG exclusions on defense lending.

While one investor at a large credit firm called into question the whole purpose of ESG in a Trumpian world, describing it as an anacronym, others urged caution, especially in the life-and-death business of tooling up for war.

Creditors will still be funding a private company whose products kill people and destroy things, the industry analyst at the asset manger says, and the paying out of dividends and shareholder buybacks will always be hard to defend.

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